At the same time, we lowered our issue ratings on Nokia's unsecured debt to 'BB-' from 'BB+'. The recovery rating on this debt remains at '3', reflecting our expectation of meaningful (50%-70%) recovery prospects in the event of a payment default.

Rationale

The rating actions reflect a downward revision of our estimates of revenues and profitability for Nokia's smartphone operations in 2012 and 2013. We have subsequently also revised our cash flow assumptions, including the impact from Nokia's restructuring of its Devices and Services division. In line with our criteria, we have therefore revised our assessment of Nokia's business risk profile to "weak" from "fair" and that of the financial risk profile to "significant" from "intermediate".

We now assume that Nokia's smartphone operations will post lower revenues than we previously anticipated over the coming quarters. We also believe that consolidated revenues for 2012 will show a decline of 16%-19% and that the company will post a non-IFRS operating loss (that is, not under International Financial Reporting Standards) before restructuring costs.

Nokia's revenues could stabilize in 2013 if growth from Lumia smartphones is able to offset the revenue decline from smartphones using the Symbian operating system and, to a lesser extent, from mobile phones. However, we still foresee Nokia posting a low single-digit non-IFRS operating margin in 2013.

We have lowered our volume assumptions for Nokia's smartphones because the company's market share continues to decline. Nokia held 7.0% of the smartphone market in the second quarter of 2012, down from 12.6% in the fourth quarter of 2011, according to market research company Strategy Analytics. Because Symbian devices still represent the largest portion of Nokia's sales by volume, we think Nokia's market share could decline further. We have also lowered our price assumptions for Nokia's smartphones following the price decline of Lumia phones to EUR186 in the second quarter of this year, compared with EUR220 in the first quarter. To defend its market share, we believe that Nokia might lower the price of Lumia phones further in the coming quarters. We expect Nokia to launch new models, notably those based on the Windows Phone 8 operating system, but we think it could take some time before this can help stabilize revenues.

We have also incorporated the recent drop in the company's gross margin for the smartphone segment to 1.7% in the second quarter of 2012, which resulted partly from EUR220 million of inventory-related allowances for Lumia, Symbian, and MeeGo devices. Depending on volumes sold in the future, we think that additional charges could affect future gross margins. Nokia's restructuring of its Devices and Services division and Telecom Network Equipment division (NSN) now targets a combined cost reduction of EUR3.3 billion by the end of 2013. However, we expect that this will only partly offset declining revenues and we expect the group's non-IFRS operating margins to remain negative over the coming quarters.

In our updated base-case assessment, we now expect Nokia to generate negative consolidated free operating cash flow (FOCF) of about minus EUR2 billion in 2012, and slightly negative FOCF in 2013. This FOCF forecast incorporates our assumption of weaker profitability and the company's plan for cash restructuring outflows of EUR1.75 billion over the next 18 months. We continue to view Nokia's cash position as a positive factor, but we expect net cash to fall to less than EUR3 billion by Dec. 31, 2012, from EUR4.2 billion on June 30, 2012. The sharp decline includes cash restructuring outflows and excludes the possible benefits from divestments.

Liquidity

The short-term rating is 'B'. We assess the group's liquidity as "strong," as defined in our criteria. In our opinion, the group's strong liquidity can more than cover its needs over the near term, even if EBITDA were to decline sharply for a limited period or if NSN were unable to draw on a EUR750 million multicurrency revolving credit facility (RCF). The group has good relationships with its banks, in our view.

Nokia's main liquidity sources over the next 12 months comprise:

-- Our assumption of consolidated surplus cash of about EUR5 billion. As of June 30, 2012, the group's liquid assets totaled EUR9.4 billion, including EUR1.9 billion in cash and EUR7.5 billion in short-term marketable securities;

-- An undrawn committed RCF of EUR1.5 billion maturing in March 2016, with no financial covenants; and

-- NSN's EUR750 million RCF, maturing in June 2015, which contains maintenance financial covenants. We believe that headroom under NSN's covenants should be adequate over the next few quarters.

Against these sources, we anticipate the following liquidity uses:

-- Negative group FOCF of about EUR1 billion-EUR1.5 billion in the second half of 2012 and slightly negative FOCF in 2013, including cash restructuring outlays relating to NSN and the Devices and Services division; and

-- Debt amortization slightly in excess of EUR1 billion over the next 12 months, which primarily relates to debt maturities at NSN, and no other debt maturities before 2014.

Recovery analysis

The 'BB-' issue rating on Nokia's senior unsecured notes is at the same level as the corporate credit rating. The recovery rating on these instruments remains at '3,' indicating our expectation of meaningful (50%-70%) recovery prospects for debtholders in the event of a payment default. In line with our recovery criteria, the recovery ratings on unsecured debt issued by corporate entities with a corporate credit rating of 'BB-' or higher are generally capped at '3' to account for the possibility that their recovery prospects are at greater risk of being impaired by the issuance of additional priority or pari passu debt before default.

The recovery ratings and issue ratings are underpinned by our valuation of the group as a going concern and by Nokia's base in Finland, which we view as having a relatively creditor-friendly insolvency regime. However, the ratings factor in the notes' unsecured nature and that the documentation contains typical investment-grade protection. All of the group's debt ranks pari passu and is issued on an unsecured basis, with limited documentary protection. The noteholders benefit from a negative-pledge clause, with notable carve-outs to exclude NSN.

To determine recoveries, we simulate a hypothetical default scenario. In our view, a default of the company would most likely be due to a continued decline in revenues and market share, inability to reduce costs, continuous significant use of cash to invest in new technologies, and no improvement in operating performance. We have revised our hypothetical default year to 2016 from 2019, as a result of the rapidly deteriorating revenue and operating margins at Nokia's Devices and Services division. At the hypothetical point of default, we envisage annual EBITDA to have declined to about EUR695 million.

Our stressed enterprise valuation at our hypothetical point of default in 2016 is about EUR2.8 billion, equivalent to a stressed EBITDA multiple of 4.0x. After deducting priority liabilities of EUR320 million, which mainly comprise enforcement costs, other interest-bearing liabilities, and about 50% of the group's current pension deficit, we see about EUR2.5 billion remaining for unsecured debtholders. We envisage about EUR5 billion of debt outstanding at default (including six months of prepetition interest), assuming that debt maturing in 2014 is refinanced and the EUR1.5 billion RCF maturing in 2016 is fully drawn at default.

In calculating Nokia's stressed enterprise value, we exclude NSN, which we view as a stand-alone entity with its own financing arrangements and no guarantees from Nokia. We also exclude debt relating to NSN from our postdefault calculations. If value were to be obtained from NSN at our hypothetical point of default, it might enhance recovery prospects. However, this is unlikely to have an impact on the recovery rating, which is capped at '3' because the notes are unsecured.

Outlook

The negative outlook reflects the possibility of a downgrade over the next 12 months if the non-IFRS operating margin of Nokia's Devices and Services division or consolidated FOCF remains significantly negative, since this would reduce Nokia's net cash position further. This could be the case for instance if revenues from Lumia smartphones did not increase significantly during 2013 or if margins deteriorated further.

We could revise the outlook to stable if revenues in the Devices and Services division stabilized and non-IFRS operating margins returned to breakeven.

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